Knightian Uncertainty

Uncertainty Outside and Inside Economic Models

Lars Peter Hansen

Asset pricing theory has long recognized that financial markets compensate investors who are exposed to some components of uncertainty. This is where macroeconomics comes into play. The economy-wide shocks, the primary concern of macroeconomists, by their nature are not diversifiable. Exposures to these shocks cannot be averaged out with exposures to other shocks. Thus returns on assets that depend on these macroeconomic shocks reflect “risk” premia and are a linchpin connecting macroeconomic uncertainty to financial markets.

Information Inertia

Philipp Illeditsch, Scott Condie, Jayant Ganguli

We study how information about an asset affects optimal portfolios and equilibrium asset prices when investors are not sure about the model that predicts future asset values and thus treat the information as ambiguous. We show that this ambiguity leads to optimal portfolios that are insensitive to news even though there are no information processing costs or other market frictions. In equilibrium, we show that stock prices may not react to public information that is worse than expected and this mispricing of bad news leads to profitable trading strategies based on public information.

Economic Policy Uncertainty and Asset Price Volatility

Maxim Ulrich

We document that fear about misspecified economic and central bank policies explain 45% of variations in bond option implied volatilities and interest rate volatilities. We endogenize this empirical pattern with a parsimonious equilibrium asset pricing model. In equilibrium, volatility is endogenously driven by fear of not knowing the data generating process that drives future economic and future central bank policies. An increase in either of these two uncertainties steepens the yield curve and increases the volatility in asset and option markets.